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2 This report was prepared by Jane Ambachtsheer and Ryan Pollice of Mercer and Ed Waitzer and Sean Vanderpol of Stikeman Elliott LLP. The report is the product of the collaborative efforts of Mercer, Stikeman Elliott LLP, and the Generation Foundation and has drawn on the expertise and advice of numerous specialists and practitioners. We thank everyone who contributed to this process, and in particular, acknowledge those who shared extensive time and insight with us. The views expressed in this report are those of the authors and do not necessarily reflect the views of those who participated in the consultation. We accept any errors in this document as our own. ABOUT THE GENERATION FOUNDATION The Generation Foundation (the Foundation ) was part of the original vision of Generation Investment Management LLP when the firm was founded in Charged with a mission of strengthening the field of sustainable capitalism, the Foundation s funding is based on receiving a distribution from Generation Investment Management s annual profitability. For more information, visit ABOUT MERCER Mercer is a global consulting leader in talent, health, retirement, and investments. Mercer helps clients around the world advance the health, wealth, and performance of their most vital asset their people. Mercer is a wholly owned subsidiary of Marsh & McLennan Companies (NYSE: MMC), a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy, and human capital. Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in providing risk and reinsurance intermediary services; and Oliver Wyman, a global leader in management consulting. For more information, visit ABOUT STIKEMAN ELLIOTT LLP Stikeman Elliott is one of Canada s leading business law firms, with offices in Toronto, Montréal, Ottawa, Calgary, Vancouver, London, New York, and Sydney. For more information, visit

3 Contents Foreword... 3 Executive Summary... 4 An Overview of Loyalty-driven Securities... 8 Findings from the Consultation Building on the Consultation s Findings: If Not Loyalty-Driven Securities, Then What? Conclusion and Next Steps Acknowledgements Appendix A: Methodology Appendix B: Legal Perspectives on the Use of Loyalty-driven Securities Appendix C: Select Quotes from the Consultation Notes

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5 ForEwOrd Investors and other market participants are increasingly recognising that fostering longer-horizon thinking and behaviour in financial markets is critical. Concerns that an excessive short-term focus can undermine the creation of long-term value are central to the work of the Generation Foundation and many others committed to exploring this topic and potential solutions. In 2012, the Generation Foundation published Sustainable Capitalism, which identifies five actions that financial market stakeholders could pursue to counteract many of the sources of short-termism and promote financial markets that operate with the goal of promoting long-term sustainable economic growth. The actions include: Identify and incorporate risks from stranded assets. Mandate integrated reporting. End the default practice of issuing quarterly earnings guidance. Align compensation structures with long-term sustainable performance. Encourage long-term investing with loyalty-driven securities. Investors and other market participants are increasingly recognising that fostering longerhorizon thinking and behaviour in financial markets is critical. Generation has committed to undertaking and supporting additional research in order to further develop these actions. In this spirit, we commissioned Mercer and Stikeman Elliott LLP to manage a series of consultations to explore the relationship between issuers and their shareholders by considering the potential use of loyalty-driven securities by issuers as a means of cultivating a base of long-term shareholders. Loyalty-driven securities have been the subject of increasing debate in terms of its potential to more closely align company executives and long-term shareholders towards a greater focus on long-term value creation. We believe that a more robust relationship between companies and their long-term owners can support more sustainable capitalism. The findings from our consultation suggest this is a widely held view. Although the consultations in this study revealed why loyalty-driven securities face challenges for implementation, the study did highlight other ways in which patient capital can be incentivised. We look forward to further exploring the alternative ideas set forth in this report in pursuit of our aim to achieve long-term oriented alignment in financial markets. THE GENERATION FOUNDATION 3

6 EXECUTIVE SUMMARY Through building a base of more patient capital in the form of a more stable group of long-term shareholders, the intended aim would be to reduce shortterm pressures on boards and senior executives and better align companies and investors with a shared focus on long-term value creation. The concept of loyalty-driven securities is a share structure that provides differentiated rights or rewards to a group of shareholders identified on the basis of the tenure of their shareholding. Various models include the use of extra dividends, warrants, or additional voting rights granted to investors that achieve minimum holding periods (for example, shareholders that held their shares for three or more years would be eligible). Loyalty-driven securities have been presented as a potential means by which issuers could cultivate a base of long-term shareholders by incentivising longer holding periods. Through building a base of more patient capital in the form of a more stable group of long-term shareholders, the intended aim would be to reduce shortterm pressures on boards and senior executives and better align companies and investors with a shared focus on long-term value creation. Discussions about the potential use of loyalty-driven securities have occurred against the backdrop of broader debates on the differential treatment of shareholders as a means of curbing short-termism. For example, the Kay Review most recently discussed the potential for offering enhanced rights to longer-term investors and challenging the one share, one vote principle of Anglo-Saxon corporate governance. The European Commission is also reportedly considering a proposal to give loyal shareholders extra voting influence. These developments have occurred alongside other observers questioning whether giving long-term shareholders greater rights could improve corporate governance. In Sustainable Capitalism, loyalty-driven securities were one of five key proposals the Generation Foundation identified as a potential tool to accelerate the transition to sustainable capitalism. While the concept was appealing, it was largely contested. Thus, the foundation commissioned Mercer and Stikeman Elliott LLP to manage a series of consultations to explore the relationship between issuers and their shareholders by considering the potential use of loyalty-driven securities by issuers as a means of cultivating a base of long-term shareholders. This report presents the findings from a series of consultations held globally to determine the extent to which actors across the investment chain view loyalty-driven securities as both attractive and likely to be effective. Over an eight-month period, Mercer and Stikeman Elliott LLP organised individual interviews and group discussions held via teleconference and in-person in New York, Toronto, London, Sydney, and Melbourne. In all, more than 120 individuals provided their valuable insights and feedback. Appendix A of this report outlines the methodology behind the consultation and the findings. 4

7 KEY FINDINGS Our consultations indicate that there is broad consensus around the belief that short-term behaviour on the part of investors is driving non-optimal behaviour by companies, a problem exacerbated by corporate and investment-manager norms and incentive structures. However, we found little support for the introduction of loyalty-driven securities. A small minority of participants believed loyalty dividends and L-shares (special warrants) may alter investor behaviour and could produce ancillary benefits. However, loyalty-driven securities were, in general, not seen as a measure that would contribute significantly (and positively) to the perceived problems or address what were viewed as the root sources of short-term pressures (misaligned incentives throughout the investment chain), even if adopted on a widespread basis. With the exception of a small number of participants in the consultations (including existing issuers of loyalty-driven securities), issuers and investors consulted did not view loyalty-driven securities (and the commensurate differential rights for shareholders of a certain holding period) as an attractive proposition. The key criticisms of the concept are outlined below. Discrimination between shareholders The endorsement of the principle of one class, one share, one vote as corporate governance best practice represents a significant barrier to the widespread introduction and acceptance of loyalty-driven securities by both issuers and investors. Many participants were of the view that differentiated rights and/or dual-class share structures were not supportive of strong and effective corporate governance systems. Therefore, a mechanism to address short-termism that relies on contravening this principle was not viewed favourably. Risk of unintended consequences Investors raised concerns that eligibility criteria based solely on holding period (in proposed and existing examples to date) would favour certain types of investors and may produce outcomes that may not be consistent with the objectives of loyaltydriven securities. Administrative complexities From a practical perspective, the introduction and administration of loyalty-driven securities was viewed as creating significant complexities around tracking tenure of ownership, share transfer, registration, and custody. While these barriers could be addressed for example, Bolton and Samama propose the use of SEDOL codes for tracking of L-shares participants in the consultation did not believe the demand necessary to drive these changes was likely to develop. 1 Weak incentives The nature of the reward (extra voting rights or nominal increased dividend) was not viewed as significant enough to incentivise a desired change in behaviour. Further, a number of participants expressed the view that the amount of the reward was unlikely to be significant enough to forgo securities lending revenues. No consensus that loyalty-driven securities address root causes of short-termism A large majority of those consulted did not agree that an incentive or reward for holding shares for a specified period of time was directly related to addressing sources of short-term pressures on companies. There was significant debate as to whether holding periods of institutional investors had declined significantly and if so, how declining holding periods would function to generate short-term pressures that, in turn, influence corporate decision-makers. In general, those that participated in the consultation (including most issuers consulted) did not equate the problem to an issue of declining holding periods and therefore viewed loyalty-driven securities as unlikely to incentivise significant constructive change in behaviour by investors or reduce short-term pressures on companies. 5

8 BUILDING ON THE CONSULTATION S FINDINGS: IF NOT L-SHARES, THEN WHAT? Discussions led to three distinct but interconnected priority themes for continued focus. Each of these three areas plays a critical role in establishing a relationship whereby long-horizon investors and companies make sound decisions, and have the time and infrastructure to stick by them. Board/investment committee education programs present an opportunity to either include content on these themes, or develop curriculum specific to them. Some examples exist (for example, the Rotman School of Management s Board Effectiveness Program) but room for more exists. 1. Longer time horizons for investment analysis Applied to investment opportunities and company projects, a longer-term outlook allows for increased focus on long-term value drivers, including innovation and management of different forms of capital (physical, financial, human). This speaks to the core of short-termism, as it relates to the mindset that individuals (in investment firms or companies) use to make decisions on a day-to-day basis. 2. Aligned frameworks for performance measurement and reward A longer-term perspective for value creation and delivery is only possible if supported by appropriately aligned performance measurement and reward frameworks. Otherwise, individuals (in investment firms or companies) will be penalised for decisions that may not be rewarded by shortterm share price movements but will pay off over the long term. 3. Stronger relationships between companies and investors A more constructive relationship between companies and their long-horizon investors is required to deliver longer-term value creation. If investors are going to support long-term decisions, which may take some time to pay off, they need to have faith in the strategy and also the executive team that will execute it. This may require more information on paper, and sometimes in person. We believe a number of opportunities exist across these themes for near term action. These include: a. Supporting better-informed fiduciary oversight. A proactive intervention in the trustee world with the goal of informing and equipping fiduciaries to understand and act on their responsibilities could be an important step forward (an idea also highlighted in Generation s 2012 Sustainable Capitalism paper). The goal is not just to inform, but to put concepts into practice. For example: A database of sustainable financial marketcertified candidates for board/trustee/investment committees could be developed, similar to the US Diverse Director Datasource (for corporate board candidates). This could be developed as a global model, with local partnerships. Policy and regulatory frameworks play a critical role in shaping behaviour, and further focus on how they help or hinder behaviour that is conducive to long-horizon value creation is warranted (by investors and companies). b. Move from talk to action. The past five years have seen significant focus within the investment community on pioneering new ways to do things to better align beneficiaries, fiduciaries, investors, and companies. Now is the time to move beyond blue sky discussions and put these revised systems and frameworks into practice. For example: Numerous investment strategies exist that have long-horizon investment as their core proposition. Investors can actively preference long-horizon strategies as they replace and select new fund managers. The key point is that low-turnover (or long-horizon) strategies are out there but they need to be used. Further, asset owners should speak to their managers about how they value longer-term ESG risks and exercise their rights as shareholders. We should not underestimate the ability for client demand to change behaviour at the fund manager level. A live shadow monitoring pilot could establish a wider set of metrics against which to monitor and report fund manager performance to clients. This process could facilitate active client feedback to then refine the process and subsequently embed it as the new norm. The refined metrics would look beyond relative benchmark performance (such as return on invested capital) as well as performance on voting and monitoring. 6

9 Alignment of incentives in the executive compensation context is also an area that has seen considerable focus by industry commentators. What is needed is for more implementation of the best ideas into practice. This requires more demand from shareholders, but an active project to facilitate match-making between long-horizon investors and long-horizon companies to proactively tackle this issue could help to set important industry precedents. c. Change the dialogue between owners and companies. A key takeaway from the consultation is that we need to find a new and better way for investors and companies to have a relationship. On the active side, this could be a natural evolution of lower-turnover portfolios with heightened focus on engagement. For passive managers, one-to-one engagements with issuers are of course much more challenging. Thus, a key opportunity is to establish a mechanism for passive managers and large issuers to come together to address major systemic issues and develop relevant standards. Establish an investor-issuer council for systemic risk focused on establishing a formal relationship between institutional shareholders and companies. It would be important for this to include commercial passive managers, given the large and growing assets under management. Launch a campaign to encourage analysts and investors to ask companies during quarterly earnings calls and other meetings what their plans are to build wealth over a five- to sevenyear time horizon. Then, ensure voting decisions are executed consistent with this time frame. Mercer, Stikeman Elliot LLP, and the Generation Foundation will continue to work independently and collaboratively to action these concepts and support a more proactive approach to addressing issues or shorttermism and systemic risk across the investment chain. We encourage others to share this proactive approach and look forward to collaborating for a better financial future for all. 7

10 1 AN OVERVIEW OF LOYALTY- DRIVEN SECURITIES THE NATURE OF THE PROBLEM Several definitions and descriptions have been offered to provide context for the nature of the problems related to short-termism. 2 The Business Roundtable Institute for Corporate Ethics and CFA Centre for Financial Market Integrity defined short-termism as the excessive focus of some corporate leaders, investors, and analysts on short-term, quarterly earnings and a lack of attention to the strategy, fundamentals, and conventional approaches to long-term value creation. 3 The common theme of the various definitions is that an excessive focus on the short-term results in decision-making or behaviour that comes at the expense of, or results in, suboptimal long-term effects. Heightened interest in short-termism also reflects the belief that the causes of short-termism as observed today are products of poorly designed organisational incentives and failures of corporate governance systems rather than simply a result of information asymmetry, technological innovation, or the cognitive limits of decision-makers. 4 Relating to the perceived need to insulate boards and senior executives from short-term pressures, a set of proposals is receiving increasing attention that suggest distinguishing between long- and short-term shareholders by allocating differentiated shareholder rights. Proposals have included limiting proxy access to shareholders of a specified minimum duration, inferior voting rights for short-term shareholders as well as increasing voting rights for long-term shareholders. 5 Other proposals have highlighted various means to more directly penalise short-term investing 6 or reward longer-term shareholding using tax and subsidy measures or financial rewards in the form of an extra dividend, for example.... an excessive focus on the shortterm results in decision-making or behaviour that comes at the expense of, or results in, suboptimal long-term effects. 8

11 For the purpose of this consultation, we were chiefly concerned with measures that could be adopted and implemented by individual companies as a means of cultivating a base of long-term shareholders rather than tax or other regulatory-based measures. LOYALTY-DRIVEN SECURITIES Loyalty-driven securities allocate differential rights to shareholders who hold their shares continuously for a minimum specified period of time. In this way, loyaltydriven securities have been presented as a potential means by which companies could build a base of more patient capital that is intended to reduce short-term pressures on the company and better align companies and investors with a focus on long-term value creation. Conceptually, such proposals have been supported by those that argue that the existence of a group of longterm shareholders can mitigate pressures for short-term behaviour, either through monitoring and a disciplinary role or by mitigating pressures coming from other, more short-term shareholders of the company. 7 While in many cases, this is done informally through investor relations activities, various proposals have called for companies to extend this principle by incentivising long-term shareholders through the issuance of what have been termed loyalty-driven securities. Emerging models outlined below, such as the loyalty dividend or the loyalty shares (L-shares) concept 8 as well as the use of double or extra voting rights provides suggestions for how this could be achieved. MODELS FOR IMPLEMENTATION Voting rights: Multiple or double voting rights that vest if shares are held continuously for the minimum loyalty period. 9 Dividends: The awarding of an extra or preferential dividend or share bonus on a one-time or recurring basis for those shares that are held continuously for the minimum loyalty period. 10 Warrants (L-shares): A call warrant would be granted to shares that are held continuously for the minimum loyalty period that vest at the expiration of the loyalty period and confer the right to purchase a pre-determined number of shares at a pre-determined price. 11 Bolton and Samama have been integral to the development of this concept and what they refer to as L-shares. 12 Common characteristics of loyalty-driven securities include: The loyalty rights would be available to the shareholder and/or exercisable if the share is held for the specified loyalty period of, for example, three years. There would be a need for registrars to establish and track which shareholders qualify according to the eligibility criteria. In France, for example, shareholders are required to convert or transfer their shares to registered shares to be eligible (in either directly or managed form). The share must be held continuously. If the share is sold before the loyalty period ends, the rights are lost. Under the various proposals reviewed, the transfer of shares pursuant to a stock-lending arrangement would terminate the share lender s period of ownership and therefore result in the loss of the rights attached to the loyalty-driven security. All shareholders would be eligible to participate provided they meet the qualifying conditions, whether defined by holding period or other criteria. Issuers or policy makers may, in turn, seek to cap the benefit qualifying shareholders may receive. WHY CONSIDER LOYALTY-DRIVEN SECURITIES? As detailed below, loyalty-driven securities or loyalty rewards have been presented by some as a potential means by which issuers could cultivate a base of longterm shareholders by incentivising longer holding periods. Indeed, discussions about the potential use of loyalty-driven securities have occurred against the backdrop of broader debates on the differential treatment of shareholders as a means of curbing shorttermism. For example, the Kay Review most recently discussed the potential for offering enhanced rights to longer-term investors and challenging the oneshare, one-vote principle of Anglo-Saxon corporate governance. The European Commission is also reportedly considering a proposal to give loyal shareholders extra voting influence. These developments have occurred alongside other observers questioning whether giving long-term shareholders greater rights could improve corporate governance. 13 9

12 EXAMPLES OF LOYALTY-DRIVEN SECURITIES ISSUED TO DATE Loyalty Extra Voting Rights In France, corporate law permits the awarding of double voting rights to reward long-term shareholders who have held their shares continuously in registered form for a minimum of two years (although the articles of association may provide for a required holding period of greater than two years). To date, more than 70 issuers in the Société des Bourses Françaises 120 Index have articles of association that provide such rights. Loyalty Dividends In France, several issuers have proposed and won shareholder approval for the issuance of loyalty dividends to shareholders who hold their shares in registered form for at least two years (the minimum period may be longer and is set by the issuer). By law, corporations are limited to issuing an extra dividend that is no greater than 10% of the regular dividend. Further, the number of shares eligible for this extra dividend is restricted. A sample of French issuers of loyalty dividends includes Air Liquide, Credit Agricole, Lafarge, L Oreal, and Group SEB. Outside of France, loyalty dividends have been considered but not implemented by Netherlands-based Royal DSM NV. In addition to loyalty dividends, some companies have occasionally granted one-time bonus shares. For example, shareholders of Australia-based Telstra that participated under the company s 2006 initial public offering were entitled to receive one bonus Telstra common share for every 25 common shares acquired under the offering, provided the shareholder held his or her shares until 15 May Additional examples can be found in the United Kingdom (British Telecommunications PLC, Standard Life), Singapore (Singapore Telecom), and Germany (Deutsche Telecom). Loyalty Warrants (L-shares) The use of loyalty warrants is still at the conceptual stage. As an example of the proposal, Bolton and Samama cite the decision by the French company Michelin in 1991 to grant one-call warrant for every 10 shares held following a dividend cut, exercisable at a fouryear horizon at an out-of-the-money strike price of FRF 200 (compared with FRF 115 at the time of the announcement).... loyalty rewards have been presented by some as a potential means by which issuers could cultivate a base of long-term shareholders by incentivising longer holding periods. ARGUMENTS MADE IN SUPPORT OF THE USE OF LOYALTY-DRIVEN SECURITIES Proponents argue that to the extent that loyaltydriven securities serve to attract and retain longterm investors, they may assist a company seeking to develop a base of longer-term shareholders on the premise that this will reduce short-term pressure on company management. Loyalty-driven securities may serve as a means of transferring wealth and/or rights, empowering long-term shareholders with greater influence over corporate governance matters. To the extent there is a correlation between longer-term holding periods and monitoring costs, loyalty rewards serve as a reward for the latter. For example, some have argued that loyalty dividends can be seen as a means of compensating long-term investors for the cost of monitoring/ engagement activities. 14 In turn, investor stewardship done well is increasingly viewed as beneficial to company performance and general market functioning. 15 The administration of a loyalty reward scheme may also support conditions for improved shareholder identification and communication as the requirement to register shares to be eligible to receive the reward may increase transparency, enabling the company to have better knowledge of its shareholder base, which may facilitate better dialogue. Some have argued that loyalty rewards for example, loyalty dividends serve as a mechanism for reducing the available stock for lending purposes and increase borrowing costs. This is seen as beneficial to those that feel stock lending is a destabilising activity. 16 Another perceived attraction is that issuers may adopt the use of loyalty-driven securities on their own initiative and structure it to fit their particular circumstances provided it is consistent with applicable corporate law. As outlined in the Appendix, the use of differentiated rights as contemplated under certain models for loyaltydriven securities are permitted by corporate law in many jurisdictions provided it is authorised by its articles of incorporation. 10

13 2 FINDINGS FROM THE CONSULTATION OBJECTIVES In setting out to test this concept with key actors across the issuer and investment communities our objectives were to: 1. Determine market sentiment with regards to whether loyalty-driven securities are viewed as attractive proposals for companies looking to incentivise and cultivate a base of longterm shareholders. 2. Determine the extent to which actors across the investment chain view loyalty-driven securities as a measure that, if adopted more broadly, would be effective in promoting longer horizons among investors and a greater alignment of company executives and long-term shareholder interests. The following section presents the key findings from the consultation and details the range of opinions we received, areas where consensus emerged, and where there was disagreement among those consulted. FINDINGS Loyalty-driven securities were generally not seen as a measure that would contribute significantly (and positively) to the perceived problems or address the root sources of short-term pressures, even if adopted on a widespread basis. With the exception of a small number of participants in the consultations (including existing issuers of loyalty-driven securities), issuers and investors consulted did not view loyalty-driven securities (and the commensurate differential rights for shareholders of a certain holding period) as an attractive proposition. The concept was not generally viewed as a strong incentive to drive changes in investment behaviour viewed as the source of short-term pressures in markets. Participants expressed strong beliefs that loyalty-driven securities result in discrimination between shareholders, risk entrenchment problems, and present administrative complexities in their implementation. Where support for loyalty-driven securities was voiced, warrants were seen as having the greatest potential to lengthen the time horizon in which an investor forms his or her opinion of the company s prospects, in turn encouraging a greater focus on a company s fundamentals, governance, and long-term strategy. The endorsement of the principle of one share, one vote (and one dividend) as corporate governance best practice represents a significant barrier to the endorsement of loyalty-driven securities. An overwhelming majority of participants shared the view that the use of loyalty-driven securities by publicly traded companies would amount to permitted discrimination among shareholders, treating one class of shareholders that is eligible to and opts to receive the reward in a different way to the rest. This was particularly the case for loyalty-driven 11

14 securities that grant double or multiple voting rights. Nearly all participants were of the view that differentiated rights and/or dual-class share structures were not supportive of strong and effective corporate governance systems and could lead to a negative performance drag. The potential contribution of loyalty-driven securities to the concentration of voting rights (most apparent in the case of shares that provide extra voting rights, but also in the case of loyalty warrants over time) was seen to risk leading to agency and entrenchment problems. As a long-term investor, we see a number of issues with implementing loyalty shares and would not support an issuer moving to a loyalty-share structure. Our main concern is that in providing enhanced benefits of extra voting and/ or dividend rights to a select group of shareholders, loyalty shares create dual class structures that are not conducive to creating strong and effective corporate governance. The most effective governance results from ownership structures that provide voting rights in direct proportion to ownership as no one shareholder or group of shareholders can exert influence that is not in direct relationship to the size of their investment. Ontario Teachers Pension Plan Widespread concerns were raised that eligibility criteria based solely on holding period would preference certain types of investors and may lead to perverse or unintended outcomes. Concerns were raised that eligibility criteria based solely on holding period could reward insiders or founders or long-term, disengaged investors an outcome that would be counter-intuitive to the objectives. On this latter issue, a common criticism of the proposals was that passive (index) managers will, by their very nature, be a long-term holder of the shares of index constituents. Views were put forth that while some passive managers will exhibit active ownership-type behaviour, others put much less focus on their processes around share voting and company dialogue and do not represent an engaged shareholder. There was also considerable debate as to whether holding period was a sufficient defining characteristic of shareholder loyalty or long-term investing. In general, two descriptions of long-term shareholders were articulated: 1) a long-term shareholder is a shareholder who makes his or her investment decisions based on the long-term performance prospects of the company (for example, this long-term view is the basis for your decision to invest); or 2) an engaged shareholder sees themselves as the long-term owner of a company and encourages long-term thinking. Importantly, participants were not comfortable with the notion of identifying long-term shareholders on the basis of holding period. There was also less agreement in terms of what long-term owners of a company means and what is desirable. For example, many investors said there is a need for more engaged ownership, but neither the meaning of this nor that more engaged ownership should always be equated with positive outcomes (in terms of long-term shareholder returns) were clear. Others said companies do not want engaged investors so either side may not see each other s roles in the same way. Doubts were raised as to whether the use of loyalty-driven securities would be likely to improve the quality of the communication between long-term shareholders and company executives. Providing a reward to those who continuously hold shares for a specified period of time favours passive investors who are less-incentivised to engage and who are restricted from holding shares at weights outside of the benchmark. They would have to sell the shares granted by the loyalty warrant to stay in balance with the index anyway. Why would receiving an economic reward now incentivise them to change their behaviour? Fund manager A key point is that solutions to short-termism should not be product driven [the interviewers took this to mean there should not be undue weight placed on any one part of the investment chain] the product is the share or the loyalty share and in this context took this to mean two important points. First, the weight of money in the great majority of companies is already long-term capital essentially, these shareholders will receive an incentive in the form of loyalty rewards, but really they wouldn t have behaved differently in the absence of a loyalty reward. Second, there is a group of investors in most companies that may be termed speculators, driven by arbitrage strategies and adding extra bits and pieces in the form of L-shares will not alter their behaviour they will not wait the two years. Company director The introduction and administration of loyaltydriven securities by issuers was viewed as creating significant complexities around the matter of tracking tenure of share ownership, share transfers, registration, and custody. A recurring perspective from those interviewed who were familiar with the usage of loyalty-driven securities in France was that the process to register for the reward was overly cumbersome and complex for institutional investors. One issuer termed the administrative issuers around tracking tenure of ownership as an administrative nightmare. Where eligible, none of the institutional investors we consulted with had registered to receive the loyalty dividends available from a number of French issuers. 12

15 Investors that were interviewed cited difficulties in registering and the potential time lag associated with de-registering as limiting the attractiveness of loyalty shares and imposing liquidity constraints. This was also confirmed by a French issuer (that provides a loyalty bonus dividend to registered shareholders of longer than two years) that suggested the existing process was unfriendly to large, institutional investors and particularly those outside of France. It was recognised that in other markets, the system could be more straightforward. For example, Bolton and Samama propose the use of SEDOL codes for tracking of loyalty share eligibility. However, participants in the consultation did not believe the demand necessary to drive these changes was likely to develop. The perception was that there remains limited incentive for those responsible for driving changes to implement and absorb the costs of such changes (for example, registrars, custodians). There are some regulatory developments that are more promising and loyalty rewards will effectively add complexity. Rather, we need intelligent regulation that enables simplicity and enhances the ability of key actors in the process (especially companies) to think more long term especially: (1) the integrated reporting initiative, and (2) Australian Securities and Investments Commission s Consultation Paper 187 Effective disclosure in an operating and financial review. The approach represented by these two initiatives is likely to be more effective than loyalty shares. Emphasis should be on regulation to make companies better not convoluted mechanisms to improve markets. Investor relations professional The nature of the reward and eligibility criteria tied to holding period was viewed as not significant enough to incentivise a change in behaviour. Concern was also expressed that loyalty reward schemes could be gamed. For example, shareholders could employ the use of derivatives to receive the reward while hedging exposure to the issuer s stock. Efforts are also likely to be required to limit the parameters of the reward to reduce abuses by controlling shareholders (for example, the French Code de Commerce limited the parameters of the reward, placing an upper cap on the amount of the extra dividend (no more than 10% premium to company s ordinary dividend) and a limit on the number of eligible shares (0.5% of total shares outstanding). These limits can function to negate the benefit when weighted against the process of registering for rewards, limited liquidity, and forgoing share lending (which would make an investor ineligible to receive the reward). Beyond concerns about control, there was general consensus that loyalty rewards seem unlikely to improve shareholder involvement. There were strong reservations regarding their potential effectiveness in stimulating and rewarding an active attitude of shareholders. Two themes of particular relevance emerged. First, while issuers generally speak favourably about having a stable group of long-term shareholders, they are not always necessarily keen on involving shareowners in the governance of companies. In many cases, shareholders also do not have the formal levers or rights to effectively influence companies. Second, some active shareholders will by nature not be long-horizon in their view of that particular company, and may legitimately exit when they believe an adequate return on invested capital has been achieved. Many institutional investors consulted identified with this latter point and expressed doubt that differential rights would alter this decision. The issue with solutions such as loyalty rewards is that the real issue is company value and whether to buy and hold. A mechanism such as loyalty rewards will not be sufficient to outweigh that consideration an incentive in the region proposed by loyalty shares (for instance 10% of dividends) will be marginal in relation to that fundamental value decision to be made by the investor. And it should be marginal. If loyalty shares were of a magnitude to be influential, they would probably be massively distortionary and/or dilutionary. Fund manager We need to consider what will actually change behaviour. Loyalty shares are unlikely to be of sufficient scope or weight to make a difference, and if it was that big it would likely be very disenfranchising. Over time, most of the options would be priced in and therefore would have limited longterm impact markets will quickly absorb and nothing much may change. Company director This will be gamed. As an illustration, if the incentive is sufficient to alter behaviour and the investor doesn t like the stock, then the investor will hold to loyalty maturity but will use derivatives/synthetics to get rid of the exposure. Whatever it is, there ll be people trying to arbitrage the deal Fund manager A small minority of participants believed loyalty dividends and L-shares (special warrants) may alter investor behaviour and could produce ancillary benefits. A stable base of long-term shareholders was viewed by some as being favourable insofar as this stickier capital can function to insulate the company from short-term demands. Where support did exist, it was mainly 13

16 in regards to financial rewards (in the form of extra dividends or warrants) rather than extra voting rights. Some were of the view that issuing warrants to long-term shareholders may result in better alignment between shareholders and corporate executive time horizons, functioning almost as a stock option of sorts for shareholders. As outlined by Bolton and Samama, warrants were seen as having the potential to lengthen the time horizon in which an investor forms his or her opinion of the company s prospects, in turn encouraging a greater focus on a company s fundamentals, governance, and long-term strategy. Finally, some viewed the introduction of loyalty-driven securities favourably from the perspective of the ancillary benefits that could result. For example, the potential for loyalty rewards to serve as a mechanism for reducing the available stock for lending purposes as outlined by Butler (2006, 2011) and Bolton and Samama was viewed as a positive attribute among a minority of participants who raised concerns that share lending could be a destabilising activity for equity markets and issuers. While misalignment of interests may be the ultimate issue, finding the solution that realigns incentives among the thousands of agents in the investment supply chain is a long way off. In the meantime, loyalty warrants should be supported as an incremental step in the right direction with little downside risk (entrenchment will always be a concern in any case). Providing an economic incentive in the form of a loyalty warrant responds to the simple fact that for most it is simply not in their interest to think long-term at the moment and we continue to have a cycle of funding the short term. Renowned governance expert A large majority of those consulted do not agree that an incentive or reward for holding shares for a specified period of time is directly related to addressing sources of short-term pressures on companies. Reservations about practical matters relating to the administration of loyalty-driven securities aside, a large majority of those consulted (both issuers and investors) do not agree that an incentive for holding shares for a specified period of time is directly related to addressing the sources of short-term pressures on companies. In discussing differentiated rights for long-term shareholders, participants often framed the advantages and disadvantages of loyalty-driven securities in terms of their potential to address what they viewed as the underlying issues, relationships, or incentives that result in short-term pressures. There was significant debate as to whether holding periods of institutional investors had declined significantly and if so, how declining holding periods would function to generate short-term pressures that, in turn, influence corporate decision-makers. In general, those that participated in the consultation (including most issuers consulted) did not agree with this premise and viewed loyalty-driven securities as unlikely to incentivise changes in investor behaviour that would have a direct impact on reducing short-term pressures in financial markets. We further elaborate on this issue in the next section of this report. It is hard to escape from the thought that the loyalty rewards are really directed at the symptoms as opposed to the cause of this problem. We need to direct our efforts at the causes of short-termism. Fund manager In the most general terms I have some sympathy for the view that markets are too short term in nature however, this characterisation is too broad-ranging and is simplistic. Time frames will depend a lot on the sector involved. In resources for example, time horizons for projects will be in the region of 15 years plus, and if directors and management are not thinking in those terms then they will not be optimising investment opportunities. However, other sectors will have shorter time frames. Company director Turnover is not in and of itself bad. Fund managers will trade in and out that is the nature and function of capital markets [they] need that flexibility and [it is] also important for companies to receive signals. My position as an investor is that if something has changed in the business, then loyalty shares will not change my view Being able to exit is important send a signal to companies about value and company strategy. Fund manager Turnover is not itself inherently bad or undesirable. Fund managers will have exit strategies (and that will form part of the basis for their appointment). In any case this market activity turnover, price signalling, and discovery while it may have the appearance of short-termism, is in fact an essential part of how markets operate. Asset owner You ve got to be really clear about the behaviours that you want to dampen or eliminate and those you retain and then as a separate step, construct the means to achieve that. We need to be careful about loyalty and the implied disloyalty a pejorative meaning that is misleading and just wrong it s not disloyal to have a rational exit strategy and to get out of a position. Investor relations professional 14

17 3 BUILDING ON THE CONSULTATION S FINDINGS: IF NOT LOYALTY-DRIVEN SECURITIES, THEN WHAT? THREE AREAS FOR CONTINUED FOCUS Discussions led to three distinct but interconnected priority themes for continued focus. We set forth these themes not as relevant to investors or companies, but to look at how they relate to both groups. This framing is deliberate discussions around addressing shortterm behaviour in capital markets typically focus on one group or the other, which reinforces the separation between companies and their investors and ignores the fact that they are really two sides of the same coin. It also leads to a disconnect between how company objectives and incentives are established and reported against, and how investors identify and monitor value creation. Too often, this exchange is distilled into one metric: share price. Each of these three areas plays a critical role in establishing a relationship whereby long horizon investors and companies make sound decisions, and have the time and infrastructure to stick by them. 1. Longer time horizons for investment analysis Applied to investment opportunities and company projects, a longer-term outlook allows for increased focus on long-term value drivers, including innovation and management of different forms of capital (physical, financial, and human). This speaks to the core of short-termism, as it relates to the mindset that individuals (in investment firms or companies) use to make decisions on a day-to-day basis. 2. Aligned frameworks for performance measurement and reward A longer-term perspective for value creation and delivery is only possible if supported by appropriately aligned performance measurement and reward frameworks. Otherwise, individuals (in investment firms or companies) will be penalised for decisions that may not be rewarded by short-term share price movements but will pay off over the long term. 15

18 3. Stronger relationships between companies and investors A more constructive relationship between companies and their long-horizon investors is required to deliver longer-term value creation. If investors are going to support long-term decisions, which may take some time to pay off, they need to have faith in the strategy and also the executive team that will execute it. This may require more information on paper, and sometimes in person. We now take a look at each of these focus areas: what they would mean in practice, how they may be achieved, and the barriers they face. We are certainly not the first to focus on these themes, and a range of papers explore these concepts in fuller detail. What we aim to do here is outline the key changes that will be required to address the problems associated with undue short-term behaviour by investors and companies. Focus 1: Longer Time Horizons for Investment Analysis Within the investment community, there already exist a number of asset owners and asset managers who take a truly long-term approach both in understanding their liabilities and in exercising investment decisions, at least in the way that some of their assets are managed. It is not realistic or desirable to envision an outcome where all market participants are investing for the long term, as shorter-term drivers will always play a role. We face a similar situation with regards to companies there are a growing number of examples of corporate leaders that focus on the long term and openly recruit longhorizon shareholders. But some sectors will be more short term than others as will be the motivation between some types of decisions. A recent study found that firms with investor communications that focus on the short term tend to have short-term investor bases, increased stock-price volatility, higher betas, and a higher cost of capital. Shifting the overall balance further towards a focus on value/growth of the business rather than the share price, among both investors and companies, would be ideal. The following tables set out the key changes involved in facilitating such a change and address existing barriers. Adopting Longer Time Horizons for Investment Analysis What it Means for Investors Key changes How this could be facilitated Key barriers to consider Increase the prevalence of longterm thinking. Increase the utilisation of fundamental analysis with appropriate discount rates for future cash flows. Consider environmental, social, and governance (ESG) issues more robustly to account for externalities and broader market impacts. Reflect these expectations in conceptualisation of fiduciary duty and trustee training and investor education programmes, including CFA curriculum and the CFA Future of Finance programme. 17 Adopt more broadly the investment beliefs that reflect a focus on longterm valuation creation. 18 Make a concerted effort to push this approach through the investment chain, including sell-side research. 19 Produce increased data on stranded asset risks. 20 Growth of momentum style investing. Need for investors to react to shortterm market fluctuations. Underutilisation of ESG data due to perceived lack of financial materiality; lack of standardised/ complete datasets; and lack of regulatory action to price externalities. 16

19 Adopting Longer Time Horizons for Investment Analysis What it Means for Companies Key changes How this could be facilitated Key barriers to consider Increase focus on innovation and long-term value creation. Reduce focus on doing whatever it takes to deliver short-term results. 21 Develop organisational structures that clearly articulate the type of work that executive directors are expected to do. Include a clear description of long-term strategy, progress towards previously declared long-term goals, and actions taken and investments made in pursuit of long-term goals in company reporting. Abandon quarterly reporting, as some believe it has an adverse effect on both companies and investors. Others said the issue is not the act of quarterly reporting, but the emphasis put on it. Evolve internal (corporate) and external (MBA) training programmes to reflect this approach. Decreasing tenure of CEOs can reduce time horizon over which value creation is envisioned. Motivations of various agents across capital markets drive shortterm activity of various types. Maximising shareholder value as short-term imperative has become a behavioural norm reinforced by legal and corporate infrastructure. Focus 2: Aligned Frameworks for Performance Measurement and Reward The second focus area is on building longer time horizons into performance measurement and reward. Incentives are at the heart of personal motivation, and if performance measurement and reward frameworks are not aligned with achieving long-term outcomes, it will be impossible to move the dial in this direction. Observers have highlighted the economic incentives for investors that tend to focus on short-term performance. A central cause of increasing pressure from equity markets on quarterly earnings and short-term performance is argued to be the result of the considerable pressure under which institutional fund managers are expected to perform. Performance monitoring and incentives may be driven by efforts to control or monitor parties that have been delegated investment decision-making responsibilities. The result can, in some cases, be that incentives are given to fund managers, for example, that shorten time horizons or fail to reward a longer time horizon. Several studies suggest that shareholders, placing significant value on short-term firm performance measures and stock price volatility, can put significant pressure on corporate boards and executives to deliver short-term gains in stock price that may come at the expense of balanced, long-term investment and prudent risk management aimed at generating long-term sustainable growth. Investors we consulted suggested that those entrusted to invest on behalf of those with a long-term orientation may be constrained from taking a longer-term view on the basis of how their performance is evaluated and rewarded. While significant work and debate had produced model investment terms to more fully address time horizon and engagement expectations through the International Corporate Governance Network s Model Mandate Initiative, it was felt by consultation participants that there was still a disconnect in terms of implementing variations of the model clauses in investment contracts. 22 Similarly, much work has been done to consider the problem around current models of performance measurement and executive compensation and the outcomes they drive, but we have not yet seen a solution that can drive meaningful change. Recent research by Mercer focuses on the expected turnover stated by global, EAFE and US large-cap equity managers. If we define long-term as less than 40% turnover per annum, approximately 35% of managers in these universes fall into this category. In these cases, we do tend to see compensation arrangements with a component of five-year rolling performance targets. This would suggest that this type of investing (with aligned compensation arrangements) is available, but it would require investors to actively seek it out, as twothirds of managers in these universes have annual turnover in excess of 40% per annum. 17

20 Aligned Frameworks for Performance Measurement and Reward What it Means for Investors Key changes How this could be facilitated Key barriers to consider Shift from client/agent to partnership model. Change the focus of manager meetings from short-term relative performance to longer-term objectives/strategy. Ensure compensation is commensurate to the risk-adjusted value-add of the manager s activities. Evolve mandate design to reflect longer time period, including a refocus of monitoring away from relative (benchmark or peer) performance 23 towards longer-term absolute performance and a review of how managers are executing the process/ strategy they were hired to follow. Explore allocating assets to longhorizon strategies (where suitable). Structure compensation appropriately to reflect this different approach to monitoring. Alignment can be supported through: Institute reasonable base management fees that reflect the nature of the strategy and position of the business. Use performance fees, where the calculation period is sufficiently long (e.g. 5-year periods). Measure performance on voting and engagement. Regulatory requirements that drive regular performance reviews. Mark-to-market accounting means that short-term share price movements can have a meaningful impact on funding status. Industry daily/monthly league tables. Manager career risk in periods of short-term underperformance. Investment products are sold not bought. Justification of paying a manager to watch the farm in low turnover strategies. Aligned Frameworks for Performance Measurement and Reward What it Means for Companies Key changes How this could be facilitated Key barriers to consider Establish performance measurement and executive compensation structures to put more focus and weight on long-term value-drivers such as strategy and innovation. Encourage industry associations and compensation consultants to adopt/create new approaches. Encourage investor behaviour that can support this change, e.g. through say on pay discussions. Average CEO tenure of 6 years makes concept of 5-year rolling pay period more challenging. 24 Difficult to change industry norms and practices. Investors initially (and successfully) advocated for equity compensation as a means to align executive compensation with investor interests, which had severe and unintended consequences. 18

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